The leveraged finance
market might be forgiven for feeling a little persecuted of
late.
In addition to new lending guidelines that might kill off a lot
of business for the banks, proposed risk-retention
rules state that CLOs must retain a 5% stake in any securities
that they sell. Completing the triple-whammy of hostile
regulation is the
Volcker Rule, under which CLOs have found themselves caught
in legislation aimed at hedge fund activities because many
contain some securities in their asset pools. Under Volcker,
banks would be barred from holding such investments.

The impact of the Volcker
Rule was clear for all to see in January when US CLO issuance
slumped to $3.08 billion, its lowest monthly level since July
2012, according to JPMorgan. The CLO market in the US had
surged ahead last year on the back of rampant demand for
floating-rate credit, fuelling the rise in covenant-lite
lending and attendant concerns over market discipline. CLO
issuance for 2013 was $82 billion  a 49% increase on
2012.

It is little surprise
that the January slump was so stark  banks hold around
$70 billion of CLO debt on their books.

Under
attack

"This is just the latest
regulatory attack," fumes a US-based CLO manager. "In January
CLO production was a quarter what it was in 2012. CLO spreads
have continued to widen and the CLO arbitrage is challenged. It
is very unfortunate for the CLO market, particularly in the
light of the fact that performance has been stellar. Getting a
US bank to commit to triple-A liabilities today is a Herculean
effort. If as a CLO manager you have to rely on non-banks and
foreign banks for the triple-A part of the structure it is very
difficult  you cant do it without US bank
investors."

There is little doubt
that the impact of the Volcker Rule on the CLO market is not
what the regulators were aiming for.

"With funds activities there are still a ton of questions on
what is in and out of the Volcker Rule," says Derek Bush,
partner at Cleary Gottliebs US financial institution
practice, who has been advising large US and non-US banking
organizations on implementation of the final Volcker Rule.
"Congress meant the regulators to focus on banks
involvement with private equity and hedge funds, but now
securitization has been caught up in this. No one would have
said that owning a bond in a securitization vehicle is the same
as investing in a private equity fund."

The CLO market has,
however, been impressively quick at finding ways around the
rule and by late February there had been a considerable
recovery in new monthly issuance to $5.9 billion, bringing CLO
supply for 2014 to $9.5 billion from 20 deals. New deals are
either scrapping bond buckets or issuing under Rule 3a7, which
restricts the ability to buy and sell assets in the pool.

"The Volcker Rule is
meant to address ownership interests not debt securities, and
the regulation mainly defines ownership interests based on
economic exposure," says Bush. "But the regulation also looks
to consent rights, and so an issue therefore arises in a CLO if
the investor has consent rights over the manager. But there is
scope to allow CLO activities under the rule as it stands.
There are ways to deal with those consent rights."

However, as Euromoney
went to press the CLO market was waiting for news following the
House Financial Services Subcommittee meeting on February 26:
Fed chair Janet Yellen was quoted mid-month as saying that
clarification on CLO treatment under Volcker would come
"reasonably soon".

In mid-January regulators
exempted banks existing holdings of CDOs backed by
trust-preferred securities (Trups) from the rule, conscious of
the losses that would be imposed on smaller banks by having to
dispose of these securities. The CLO market is hopeful that a
similar exemption can be made for them.

"The regulators have
issued guidance about Trups CDOs and are likely to issue
guidance on CLOs as well," reckons Bush. "They have a lot of
leeway to revise the rule or interpret the rule to solve this
issue."

Even if the treatment of
CLOs under the Volcker Rule is softened, the impact of new
leveraged lending guidelines on the banks could have a serious
impact on deal formation as the year progresses.

"The loans affected by the guidelines are the bread and
butter of the CLO market," warns the CLO manager. "The average
leverage of a first-lien covenanted loan can comfortably get
into the high threes or low fours [which would breach the
guidelines]. Today the CLO arbitrage available does not afford
you the luxury of building a book around BB-rated loans.
Single-B rated loans are the deals that make the arb work and
they can very easily get to four turns of leverage."

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